Related Search

Is a shortage of dollar funding behind recent stockmarket weakness?

New regulations have seen banks and money market funds change their cash management processes. Is this contributing to a squeeze in dollar-denominated funding?

23/02/2016

Roger Doig

Analyst, European Equities

Contributes toUnstructured Learning Time

The market selloff over the last six weeks has left many commentators scratching their heads. Banks look solvent, corporate credit looks robust outside some well flagged pockets of US high yield.

The market signals fear, but what exactly is it afraid of? “Chinese stockmarkets are falling” is an observation, not an explanation.

Is dollar funding the reason?

One part of the explanation could be a shortage of dollar funding, which is particularly pronounced in Asia. The falling oil price has been a key driver of this, as oil-producing countries see lower surplus US dollar balances.

However, there is also a structural reason for the shortage, which is the result of US banks and money market funds changing their cash management processes in response to Basel III liquidity rules and SEC rules on money market funds.

Where previously there was a degree of fungibility (i.e. mutual substitution) between US onshore dollars and the Eurodollar (offshore) market, facilitated by prime funds1 lending to offshore banks, the new rules are in the course of shifting this liquidity to US banks, whose hurdle rate for overseas lending is rather higher.

What are the specific changes?

US banks are incentivised under Basel III liquidity rules to seek retail deposits and ditch commercial non-operating deposits (essentially surplus corporate cash) which have the highest liquidity backing requirements and thus the lowest returns. JP Morgan reduced its non-operating balances by $200 billion in Q4 2015, for example. These funds will move to money market funds.

Institutional prime funds (which invest in commercial paper and certificates of deposit) have to float their net asset values and implement liquidity gates and fees under SEC rules2. Government-only money funds do not face these restrictions. However, these have to invest in cash and Treasuries.

So, while money is coming into institutional money market funds, it will flow into government-only rather than prime funds. Meanwhile on the retail side, banks will aim to grow deposits, which will be more attractive than money funds because the latter will have gates.

The likely effect of these changes is shown in Figure 1 below.

In short, by the end of this year, $1 trillion of prime fund money will have shifted to government-only funds, with US Global Systemically Important Banks (GSIBs) either shrinking their balance sheets by getting rid of non-operating deposits, or replacing some with retail deposits, but being structurally less willing than prime funds to lend offshore.

Now, any institution that has been lending in US dollars offshore will see its cost of funding increase. And there has been a lot of offshore (Eurodollar) lending (see Figure 2 below).

QE 4 on the cards?

Add to the mix the fall in the oil price, which reduces the availability of offshore dollars, and there is a double whammy. At this point banks either shrink the asset side of the balance sheet, or pay up for liquidity.

This is what happened in the eurozone in 2011 before the Long Term Refinancing Operations or in the offshore US dollar market in 2009. Central bank swap lines with the Federal Reserve (Fed) can provide emergency overnight dollar funding if required, but that is not a long-term funding strategy.

There are two conclusions we can draw from this: either one can expect international US dollar assets to shift down to a different valuation equilibrium – which we assume is the process of happening, and which will lead to a potentially lengthy period of volatility - or one can hope for the market to “come to its senses”, which is effectively a hope for a fourth round of quantitative easing (QE) from the Fed.

1. A prime fund buys high-grade corporate loans from banks and aims for returns in line with the prime rate i.e. the rate charged by banks on loans to their most credit-worthy customers.↩

2. A floating net asset value allows the daily share prices of these funds to fluctuate along with changes in the market-based value of fund assets. Liquidity fees and redemption gates are for use during times of market stress to guard against runs.↩

For professional investors and advisers only — not suitable for retail investors.

This website is not intended or approved for US investors. By accepting to enter this website you are confirming that you are not a US investor.

In visiting this site you are leaving www.schroders.com and visiting a site sponsored by Schroder Investment Management Ltd (Schroders), which is solely responsible for the website's contents.

The material on this website is issued by Schroders and contains the views and opinions of the particular individuals and is for general information only and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. Reliance should not be placed on the views and information herein when taking individual investment and/or strategic decisions. Investment strategies discussed in this website may not be available in every jurisdiction or may only be available only in institutional vehicles.

All queries about specific investment products should be directed to the Schroders office in the jurisdiction where you reside.

Cookies. Most websites use "cookies" to identify users and improve their browsing experience. Cookies are small text files that are downloaded on to a user's device by websites that the user visits. Schroders uses cookies to provide you with a better online experience and, in particular, to tell us how and when pages of our websites are visited, what our visitors' technology preferences are and whether our websites function properly. To find out more about the cookies that we use, their purpose and how you can manage them, please visit: How we use Cookies. By using this site, you agree that we may store and access cookies on your device.